I find myself bemused by the sheer number of commentators that have labeled vice presidential candidate Paul Ryan a “radical” because of his views on the federal budget. His core view – that we ought to keep federal spending as a share of GDP at a level approximately equal to where it has been for the entire lifetimes of most Americans – strikes me as far less radical than the current policy status quo.

Let’s start with some basic facts. In the post-war period in the U.S., federal spending has averaged just under 20 percent of GDP. (You can confirm this for yourself by going to the White House OMB site and downloading Table 1.2). There have clearly been some ups and downs over this period for a variety of reasons, but it has never exceeded a quarter of GDP except for 2009 – the depths of the Great Recession – when outlays reached 25.2% of GDP.

In other words, for 60 years – through military conflicts great and small, through booms and busts, through the creation and demise of countless government programs, and through tectonic shifts in the global economic landscape, the U.S. has found it possible to keep government at about 20% of GDP. And throughout this period, the economic engine of the U.S. remained the envy of the world, even now in the aftermath of the Great Recession.

Absent substantial changes to our public policies, however, U.S. government spending as a share of GDP is projected to rise at an unprecedented rate. According to the CBO’s “extended alternative fiscal scenario,” which they describe roughly as a continuation of current policies, spending as a share of GDP is projected rise to 35.7% of GDP in just the next 25 years. This seems to me to be prima facie evidence that our future fiscal problems are being driven by rising spending, rather than a lack of revenue.

Given this, what sounds more radical? Suggesting that we make cut the growth rate of spending to keep the ratio of government-to-GDP near historical levels, as Paul Ryan has suggested? Or allowing government to grow from 20% to over 35% of GDP?

Google’s definition of radical is “affecting the fundamental nature of something.” A failure to change policy course would affect the fundamental nature of the U.S. economy. Now that is radical.

If we want to avoid this, then we need to re-think the role of government. Most of the future projected growth of government is due to a rising health care costs and an aging population. One cannot slow rising health care costs and population aging simply by cutting spending, as any serious student of the budget – of which I consider Paul Ryan to be one – already knows. Nor is it obvious we really want to stop all those trends – at least some of the rise in health spending brings new health benefits, and most of us are quite happy to live longer.

What we can do is recognize that our programs need to change with the times. Remaining life expectancy today, conditional on reaching age 62, is about 50% longer than it was in the 1960s. Yet we continue to encourage people to exit the labor force early. Even worse, we have created a mentality where most Americans seem to believe that they have a God-given right to have their retirement income and health care expenses paid for by taxpayers after they reach age 62 or 65. At a minimum, we should recognize that if people are living both longer and healthier lives than they were in decades past, we ought to make them wait longer to start receiving benefits.

There are good reasons to have Social Security and Medicare. But we need to recognize that the fiscal burden they are placing on taxpayers is going to grow rapidly in the years to come, and that the best way forward is to reform them to make them sustainable for future generations. Paying for these rapid cost increases through an inefficient tax system that depresses investment, discourages entrepreneurship, penalizes work, and retards economic growth is the real “radical” solution – and the one that should work hard to avoid.

Ever since Governor Quinn proposed his plan to reform government employee pensions in Illinois, I’ve been thinking about how to blog about it. The problem is, my primary opinion is a legal one – that the proposal clearly violates the non-impairment clause of the Illinois state constitution because it threatens current employees with excluding future pay raises from pensionable earnings in contradiction of the “contractual relationship” laid out in the Illinois Pension Code – and I’m not a lawyer. Better to stick with what I am supposed to know.

So, let’s turn to economics. While the non-impairment clause prevents the state from reducing pensions, it does not affect other benefits. In particular, the state would seem free to reduce or remove subsidies for retirement health benefits without running afoul of the non-impairment clause. New research from by Steven Nyce, Sylvester Schieber, John B. Shoven, Sita Slavov, and David A. Wise suggests that doing so might be a way to lower pension costs. In short, they show that removing the employer subsidy for health benefits for early retirees would cause people to work longer. And, when people work longer they contribute more toward the pension fund and draw pensions for less time, improving the overall finances of the pension system.

In the new article, entitled “Does Retiree Health Insurance Encourage Early Retirement,” the authors investigate the relationship between employer subsidies for health insurance to retirees. The paper begins by noting that many Americans delay retirement until they reach age 65 because employment gives them access to health insurance at far better prices than they could receive in the private market (if such insurance is even available). When an employer offers subsidized health insurance to those who retire before age 65, it makes it possible for people to retire earlier than they otherwise would. Using newly-available data, the paper finds that retiree health coverage significantly increases retirements among people in their early 60s. In fact, when employers subsidize 50 percent or more of the cost of retiree health insurance (as the state of Illinois does), retirements increase by “1-3 percentage points at ages 56-61, by 5.9 percentage points (33.7 percent) at age 62, and by 6.9 percentage points (43.7 percent) at age 63. Overall, an employer contribution of 50 percent or more reduces the total number of person-years worked between ages 56 and 64 by 9.6 percent relative to no coverage.”

What does this mean for the state of Illinois? Take, for example, SURS, the State Universities Retirement System. In this system, a worker’s total retirement benefit is limited to 80% of final salary. This means that, after about 36 years of working for the state, the worker’s pension no longer increases with additional years of service. Further, state law provides that the state will pay 5% of retiree health premiums for each year of service. (Importantly, the applicable law is not the Pension Code!) So, a person who started working for the state at age 25 would, by age 62, be eligible for the maximum pension and free health benefits.

Given this deal, it is no wonder that people choose to retire before age 65. This costs the pension system, since early retirees do not contribute and they draw their pension for longer. Removing retiree health benefits would have a significant financial impact on early retirees. Back in 2006, the most recent data I could find in a quick search, the average health insurance premium for an adult age 60 – 64 on the non-group health insurance market was around $360/month. A family policy would cost about twice that. Such policies are usually less generous than employer-provided insurance and feature higher deductibles and coinsurance rates. So, a near-elderly state employee contemplating retirement might face expected monthly costs of $500 – $700 or more if they had to pick up their own health insurance, and even more if they had a dependent spouse or children.

So, suppose the state were to eliminate retiree health benefits. Faced with such costs, many people would choose to work until age 65 (or at least until age 63.5 when the COBRA law would allow them to continue to purchase health insurance under the state plan until they become eligible for Medicare at age 65). And, when people retire later, they draw pensions for less time.

Now, I am not necessarily advocating this, and certainly not across the board. There are strong arguments why for some government employees – in particular police and firefighters –the physical demands of the job make early retirement reasonable. For other government employees, such as professors, there is no strong reason why the state should be subsidizing early retirement through providing free health benefits after I stop working.

My broader point is that whatever the state does, and it must do something, it must be done in a way that does not violate the constitution. While the state cannot touch pension benefits, it is free to reduce health insurance. And, since retiree health insurance makes retirement more attractive, reducing or removing retiree health benefits would seem to be a constitutional and, based on recent research, effective way to delay retirement, which would improve the ailing pension systems’ finances.

ADDENDUM (5/30/12): Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A. In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65. Obviously, removing employer-sponsored health benefits is much more complicated and controversial in this case.

A war of words (and numbers) has broken out in the policy wonk world over the effect of Obamacare on the deficit. It is important, entertaining, and confusing. This blog attempts to bring a bit of clarity to the debate.

It began last week with an article, written by Charles Blahous and issued by the Mercatus Center, that argued that Obamacare increased the deficit. The piece was discussed in the Washington Post (and on my blog) on the day it was issued.

It took almost no time at all for Paul Krugman to denounce the study. He first began, in typically unfortunate fashion, by attacking the credibility of the author through a suggestion that Blahous was just another Koch-funded crazy who should not be believed. He then went on to make a slightly more substantive argument about the fact that Blahous’ result rested upon a view (that Krugman called “bogus”) about what Obamacare spending should be compared with.

So who is right? The point of this post is to try to provide a bit of clarity on the issue.

Before proceeding, I should disclose my own personal biases. First, I consider both Chuck Blahous and Peter Orszag to be personal friends – and I believe both would agree with that assessment. I have known and worked with both of them for over a decade. I have an incredibly high level of respect and admiration for both Chuck and Peter as public servants, as intellectuals, and as individuals. This is not the first time they have publicly tangled (they did so frequently over Social Security reform). Ideologically, I almost always find myself on the same side of issues as Chuck. But Peter is an outstanding economist, and when his views are also echoed by other highly respected economists like David Cutler of Harvard (one of the most highly respected health economists in the world, who engaged in a debate with Chuck on my Facebook page), I often find myself temporarily in a state of cognitive dissonance. When this happens, I try to figure out the core reason for the disagreement. Is it different values (e.g., perhaps one cares more about redistribution and the other more about economic efficiency)? Is it different assumptions (e.g., fundamentally different views about how the politics will play out or on how future health costs will evolve?) In such cases, two very smart people can disagree on policy, without either being “wrong.”

But this debate seems different. This is – or at least should not be – an ideological debate. The question here is deceptively simple. It is a debate over a “fact.” Either Obamacare increases the deficit, or it does not.

So who is right?

The correct answer is “it depends.”

To understand the long-term effect of any public policy change, one must first ask the question “compared to what?” And this is where Blahous and Krugman/Orszag differ.

Me: “If I look at the new spending programs under Obamacare, and compare that to any spending reductions or tax increases under Obamacare, does the program increase or decrease the deficit?”

Blahous: Over the next ten years, the increases in spending from Obamacare – Medicaid/CHIP, new exchange subsidies, making full Medicare benefit payments for an additional eight years, etc. – exceed the ways that it reduces spending or raises taxes by $346 billion through 2021. (This is based on a CBO projection of $352 billion adjusted slightly by Chuck.)

Krugman: This is just “another bogus attack on health reform.”

Orszag: Indeed. The cost savings exceed the new costs by $123 billion through 2021.

Blahous: But you are both ignoring the cost of extending the solvency of Medicare! One of the effects of Obamacare is to extend our full financing commitment to Medicare through 2024. This costs money. Add up all the things the legislation does, and it is $346 billion more than the legislation’s cost-savings.

Orszag: This is a “trick.” The Blahous analysis “begins with the observation that Medicare Part A, which covers hospital inpatient care, is prohibited from making benefit payments in excess of incoming revenue once its trust fund is exhausted. He therefore argues that the health reform act is best compared to a world in which any benefit costs above incoming revenue are simply cut off after the trust-fund exhaustion date. Then, he argues that since the health-care reform act extends the life of the trust fund, it allows more Medicare benefits to be paid in the future. Presto, the law increases the deficit by raising Medicare benefits.”

Blahous: Look guys, this is really simple. Without the ACA, Medicare would have been insolvent in 2016. Under the new legislation, we are making a binding commitment to make full benefit payments through 2024. These are real payments to real people. How can you ignore the extra commitments through 2024? After all, you claim the Medicare solvency extension as one of the achievements of the ACA.

Krugman: “OK, this is crazy. Nobody, and I mean nobody, tries to assess legislation against a baseline that assumes that Medicare will just cut off millions of seniors when the current trust fund is exhausted.”

Blahous: But under a literal interpretation of current law – which is how most budget scoring is done in Washington – a law that extends Medicare for additional years would be scored as a cost. Do you acknowledge that under a literal change in law, this legislation puts us $346 billion deeper in the hole?

Krugman: The literal law does not matter. Everyone knows that Congress is not going to allow Medicare benefits to be slashed in 2016. To suggest these costs are a cost of Obamacare is misleading. “In general, you almost always want to assess legislation against ‘current policy’, not ‘current law’; there are lots of things that legally are supposed to happen, but that everyone knows won’t, because new legislation will be passed to maintain popular tax cuts, sustain popular programs, and so on.

Blahous: But we have to abide by these budget rules in other contexts. For example, let’s look at the Alternative Minimum Tax. The Congressional Budget Office counts the revenue from the AMT in its baseline budget projections, even though it knows full well that Congress is likely to continue to provide AMT relief before that revenue is collected. Similarly with the “doc fix” in Medicare!

Orszag: Yes, but by your logic, if we just assume that Medicare benefits are cut when the trust fund runs dry, or that Social Security benefits are cut when its trust fund runs dry a few decades later, then we do not have a long term budget problem! Indeed, Chuck, you are “far too modest. The government is not legally allowed to issue any debt above the statutory limit, so (you) should have assumed the deficit would disappear when we reach that limit at or around the beginning of next year.”

Blahous: Look, when you make Medicare benefit payments, real money leaves the US Treasury. We can’t send the same check to Medicare and to Medicaid. If you want to take credit for all the benefits of the ACA – one of which was to extend Medicare – then you have to account for the Medicare commitments as well as the Medicaid ones. Even if you don’t think we would have allowed benefits to be suddenly cut, historically Congress has always enacted other savings to avert Medicare insolvency. And, now that Medicare solvency is extended through 2024, the pressure on Congress to enact further savings is reduced. So it’s not only as a matter of literal law but as a matter of practical budgetary behavior that the ACA worsens the outlook. No matter how exactly you think things would have played out under prior law, this legislation still worsens deficits by $346 billion relative to prior law.

Krugman: Don’t believe any of this. The Mercatus Center is funded by the Koch brothers. The Koch brothers, by golly!!

Blahous: Look guys, I am trying to make a real point here, not engage in character assassination. If carried to its logical conclusion, this is not only a departure from interpreting actual law, it is also fiscally dangerous. You guys are basically saying that there are no prior law restraints on Medicare spending. So every time we extend the program’s solvency, it does not cost anything!

Me: Okay, guys, thanks for clearing that up. I understand it all so much better now.

—–

So there you have it. A knock-down, drag-out battle over budget baselines. The debate is not over the cost of things like the coverage mandate. It is a debate over the proper way to account for an extension of Medicare’s solvency.

To summarize:

Relative to a world where Medicare expenditures are brought into balance with revenues within the next few years (which does appear to be required under the literal reading of current law), ACA increases Medicare expenditure and the deficit. This is the Blahous view.

Relative to a world in which we project current practice forward, ACA reduces Medicare expenditure and the deficit. This is the Krugman and Orszag view.

I think most reasonable people can understand both points. And I don’t think this really calls for name-calling and credibility-questioning. But in Washington, that is what passes for debate.

Most ordinary people probably think that what we should be doing is making some cuts, but not cut so deeply as to eliminate the entire Medicare shortfall. If so, the effect on the deficit is better than if we did nothing, but worse than if we solved the problem.

So most people probably think the “truth” (whatever that means in this context) lies somewhere in the middle.

Last week, Congress struck a deal to head off a pending 27 percent decrease in what Medicare pays to physicians. Well, head it off until the end of the year. Then we’ll be right back where we started from, except the amount of the pay cut will be even larger.

So, what’s it all about? It all goes back to an attempt in the Balanced Budget Act of 1997 to slow the rate of growth in what Medicare pays to physicians. Each year, Medicare decides how much to increase the fees it pays to physicians. In order to reduce the rate of growth in these fees, the 1997 BBA instituted something called the Sustainable Growth Rate formula to help dictate what those increases should be. In hindsight, the term has turned out to be quite ironic, since the growth rate it proposes has turned out to be anything but sustainable. In fact, Congress often overrides the changes dictated by the SGR in what has become called a “doc fix.”

The SGR formula is too complicated to discuss, but it’s basic aim is to reduce the rate of Medicare spending on physicians. Each year, Medicare projects what it thinks it will cost to care for recipients based on past behavior, inflation, and population growth. If actual spending turns out to be close to this projection, physicians are rewarded by an increase in fees the following year. On the other hand, if actual spending is too much above the projection, the SGR formula kicks in and lowers fees across the board in an attempt, over time, to bring actual spending back in line with projections.

As usually happens, in the early years the formula worked fine. Medical expenditures were in line with expectations and docs got a small increase in fees. However, in 2002, the SGR formula imposed a 5 percent cut in physician fees that was actually implemented. Then, in 2003, when the SGR formula once again dictated a fee reduction, Congress stepped in and prevented the fee cut from happening. This was the first Doc Fix. Along with the Doc Fix, Congress included language that said that the SGR formula in future years should continue to be calculated as if Congress had not imposed the Doc Fix.

In subsequent years, actual expenditure continued to be high relative to projections, and Congress continued to override the SGR formula. Since past Doc Fixes were not taken into account, each year the size of the adjustment to physician fees needed to bring payments in line with the original SGR formula has grown until now it has reached a whopping 27%. And, every year it becomes clearer that if Congress wasn’t going to let physician fees decrease by 5% or 10%, they’re certainly not going to let them decrease by 27% or 35%.

So, what should we do about the Doc Fix? The original intent of the SGR was a good one: slow down the rate of growth of healthcare spending. But, it is clear that the SGR approach doesn’t work. At this point, physicians rightfully assume that eventually Congress will pass another Doc Fix, and they will continue to get paid higher rates than the SGR would dictate. Consequently, the SGR formula has no power to persuade physicians to rein in spending.

Thus, I think the first step to is to reset the SGR. Instead of sticking to the original formula, which requires a thirty percent reduction in physician fees, in the short run we should re-base the formula, so that next year maintaining the SGR would require a much smaller decrease in fees — on the order of a few percentage points — if physicians do not reduce overall spending on their own. This would restore the original intent of the SGR, applying pressure on providers to reduce overall spending.

Next, we need to rethink the way we approach the whole problem. Even if Congress had the courage to enforce the payment reductions imposed by the SGR, the approach would still be fundamentally flawed because it creates a situation where it forces physicians to compete for an increasing share of an ever-shrinking pie. If physicians know that the total amount of money available to physicians is fixed and they expect fees to be reduced as they are under the SGR, then a rational physician who wants to maintain income will have to respond by performing more procedures. However, all physicians have this incentive, so we should expect all of them to deliver more services (some of which may not be as medically necessary), and this will force the SGR to lower physician fees even more. The result is a vicious cycle that leads to more and more care being provided without substantially increasing patient outcomes.

While it is clear the SGR has to go, it is less clear what it should be replaced with. However, the fundamental problem – that the SGR actually encourages more care – would be alleviated if we switched a greater share of provider compensation from payments for the quantity of services provided to payments for the quality of outcomes.

Since the 1960’s, Medicare has the authority to conduct pilot studies to determine whether particular innovations might reduce the cost of providing healthcare services to Medicare beneficiaries. The 2010 health reform law (PPACA) expanded this power, giving Medicare the authority to expand nationally any program that has been shown to reduce projected spending and improve quality. While many of us were disappointed by PPACA’s lack of attention to cost reduction (and quality improvement), there was reason to hope that, out of the garden of demonstration projects, a few flowers might bloom. Unfortunately, while the first group of demonstration projects has taught us something about what kinds of demonstrations we should look at in the future, none successfully reduced overall Medicare spending (including the costs of implementing the pilot programs).

Broadly speaking, the Center for Medicare and Medicaid Studies (CMS – note the government did successfully save money by removing the second “M” from the acronym!) has focused on two types of programs: disease management programs aimed at improving care for patients with chronic conditions and reduce costs by decreasing the likelihood of costly complications and hospital admissions, and value-based payment programs that attempt to reward providers for quality and efficiency of care rather than paying them for providing more care (as is the case in the standard Medicare fee-for-service model). Earlier this month, the Congressional Budget Office (CBO) released a series of reports (here and here, and summarized here and here.

The evaluations show that most programs have not reduced Medicare spending: In nearly every program involving disease management and care coordination, spending was either unchanged or increased relative to the spending that would have occurred in the absence of the program, when the fees paid to the participating organizations were considered.

The results for the Value-Based Payment initiatives were somewhat mixed. One of the four programs considered, in which CMS made bundled payments to providers to cover all hospital and physician services for patients receiving coronary artery bypass surgeries, rather than paying for each service (and each additional service) that the hospitals and physicians chose to provide, reduced overall spending by about 10 percent. The other three programs were less successful, and on average the savings generated by the four programs were far less than the costs and fees associated with running them.

So, does this mean that the demonstration projects were a failure? Not necessarily. No reasonable person thinks that reducing Medicare spending is going to be easy. If it were, we would have done it already. Even in the failed demonstration projects there are lessons to be learned about where we should look for cost savings in the future. In its issue brief, CMO lists several of these. In my mind, the two most important are the need to limit the costs of interventions and the need to move away from the fee-for-service model of care delivery.

Regarding the costs of interventions, a number of the projects CMS implemented actually did improve quality and efficiency of care. However, they were unable to generate savings sufficient to offset the fees paid to service providers and the other costs associated with the programs. It is possible that if these costs could be reduced, perhaps through a competitive bidding process, disease management programs might prove to deliver the savings we suspect they can.

Demonstrations aimed at reducing spending and increasing quality of care face significant challenges in overcoming the incentives inherent in Medicare’s fee-for-service payment system, which rewards providers for delivering more care but does not pay them for coordinating with other providers, and in the nation’s decentralized health care delivery system, which does not facilitate communication or coordination among providers. The results of those Medicare demonstrations suggest that substantial changes to payment and delivery systems will probably be necessary for programs involving disease management and care coordination or value-based payment to significantly reduce spending and either maintain or improve the quality of care provided to patients.

In light of this, the next thing to keep your eye on are is Medicare’s experiment with so-called “Accountable Care Ogranizations,” a program that will offer comprehensive provider groups bundled payments for taking care of all of a group of patients’ healthcare needs, where these payments will be based in part on how well the ACO meets certain quality goals. The Medicare ACO experiment is just getting under way now. We’ll see whether it is more successful in bringing down costs than CMS’s earlier experiments.

With all the argument in Washington about how to balance the budget, a reminder is worthwhile that none of these numbers make any sense at all! What “should” be the meaning of the government budget? And, does any number provided by anybody actually have that meaning?

In general, a budget deficit is supposed to mean that one’s current consumption exceeds income, which would indicate a decrease in wealth. Indeed, that’s the problem with a deficit – drawing down our wealth (which could even turn from positive to negative!). The U.S. Federal budget numbers fail to provide such a meaning, for several reasons.

First, the Federal budget includes ALL spending, not just consumption. Some of that spending is actually investment, such as new spending on buildings, bridges, roads, airplanes, and any long-lived military equipment. The budget does not show the breakdown between what we really use up this year, and what spending is really investing in the future.

Second, Social Security is “off-budget”, unless you are looking at a unified budget. Okay, I said that in a way that is intentionally confusing! The basic problem here is that social security is SUPPOSED to run a surplus, so that we can set aside some funds from those now working to pay them when they are retired. If it does not run a surplus to save for the retirement of the baby boom generation, then we’ll be in big trouble when the baby boom generation retires! The current social security surplus is too small for that. Then, however, the big problem is that the unified budget mixes the social security budget with the rest of federal spending. So when you see a deficit in that account, it’s really worse than it looks, because it includes the small social security SURPLUS that’s already not a big enough surplus for social security to break even!

Third, the U.S. Federal Budget is confusing about what is a “Tax Expenditure” and what is government “Spending”. A tax expenditure is really ‘spending via tax break’, as when a taxpayer gets a special credit or deduction for doing some particular activity. The Congress could instead have accomplished the exact same thing by an ACTUAL spending program, providing subsidy to the same set of eligible individuals for doing the exact same activity. So it really does not make much sense to say you want to cut spending and not raise taxes, because eliminating one of those tax breaks is really the same as eliminating an equivalent spending program.

Fourth, a Federal “mandate” might require a certain kind of spending by a firm. To take a simple example, suppose some safety regulation requires construction firms to provide a hard hat to all workers. That’s really equivalent to a tax on that firm, equal to the amount they have to spend on hard hats, where the revenue of that “tax” is spend by government on the provision of hard hats. But then the problem is that mandates are so pervasive. Some ‘true’ measure of the size of government would be HUGE, if we counted the dollar cost of all mandates as a “tax”, as if it were in the government budget.

The last-minute deal between Congress and the President managed to save the day, just before the deadline, but it’s not a very specific plan. Any coherent long term plan for serious deficit reduction will still have to include cuts to defense and cuts to entitlement programs like Social Security and Medicare. But the Republicans did not want to cut defense, the Democrats did not want to cut Medicare, and they can’t cut the large portion of the Federal budget that goes to interest payments on existing debt. So instead, in the short run, they load high percentage cuts onto the small percentage of the remaining Federal budget that could be called discretionary. Thus it seems we will experience very large cuts to items like National Parks, environmental programs, highways, training, education, and social infrastructure.

If the American people really want a government that is extremely small, especially compared to other developed economies such as those in the OECD, then the deficit problem could conceivably be solved by spending cuts alone (as long as those cuts include defense and entitlements). Certainly some Tea Party Republicans want a Federal budget that small. But I suspect that some other Republicans only think they want a Federal budget that small and would change their minds once they see the decimation of so many Federal programs.

In 2009, before the current round of cuts, the United States ranked third-to-last among the 23 OECD countries for the percentage of GDP collected by government. I’m sure we would not want to match the 48% collected by some Scandinavian countries, or even the 40% collected by other European countries. Somewhere in the middle, Canada appears with 31% of GDP collected by government. The United States stood at only 24%, which exceeds only Mexico and Chile. With only spending cuts and no increase in taxes, the U.S. could soon have the smallest government among all 23 nations of the OECD. The following graph is from the Toronto Globe and Mail.

What might this mean for our state? Illinois is quite unusual, having just raised the State income tax to cover some of the growing annual deficit. Other states with new Republican governors have drastically cut spending instead of raising taxes. These actions might nudge Illinois upward, in the ranking of states by the ratio of tax collections to total state income, but it may allow Illinois to meet more of its obligations (including unfunded pension liabilities). If Illinois did not raise any taxes, it may have had to renege on some such promises.

Republicans would tell you that smaller government and a smaller tax bite is always better for job growth. But it’s a matter of degree, and a matter of balance. A state with the smallest possible budget would have very little spending on infrastructure, road quality, sanitation, police protection, education, training, and other social services. Yet many of those programs are important for businesses to be able to function properly. The trick is to find the right balance, with spending on the minimal decent level of such programs, as necessary for businesses and employees alike.

With no increase in Federal taxes, the recent deal on cuts in spending is likely to mean cuts in all kinds of Federal discretionary spending, including grants to the states. The U.S. Congress will then be likely to enact more unfunded state mandates, which means requiring the states to spend their own money to provide basic services that the Federal government used to provide. State governors and legislators will be unhappy about these changes, with even more pressure on state governments.

It is unlikely that there will be a lot of blogs where I agree with Newt Gingrich because I see economic policy as one of weighing costs and benefits, which tends to avoid extreme positions of the sort that the former Speaker as well as his counterparts on the left tend to advocate. But, last week he came out against Paul Ryan’s plan to replace Medicare with a voucher system (you can call it premium support if you want, but it’s still a voucher system) as too great a change in the current system, saying “I am against Obamacare imposing radical change, and I would be against a conservative imposing radical change.” I have to say that I agree with Gingrich the moderate on this point.

The Ryan plan will replace the current Medicare system — where individuals go to virtually any provider they want, receive whatever treatment that provider chooses, and present the government with the bill – with one where seniors are given vouchers from the government to purchase health insurance plans from private insurers who will then manage individuals’ care in much the same way as HMOs manage care for younger people. (See a nice discussion of the Ryan plan from the Kaiser Family Foundation, here.) The insurance plans, Ryan argues, will have an incentive to reduce costs, since they are not paid for providing extra treatment, and to increase quality, since plans that provide higher quality will attract more customers. The virtues of the market will work to increase quality and decrease cost, and in order to reinforce that the value of the vouchers will be pegged to overall inflation rather than medical cost inflation. This will, by definition, slow the rate of growth of health care cost, or at least the portion of the bill that the government pays.

I agree with the sentiments expressed in the Ryan plan. Something has to be done to rein in cost, and promoting competition seems to be a good way to go. However, there are a lot of open questions about whether such a plan could really be implemented (just as there are with whether the insurance exchanges in the Patient Protection and Affordable Care Act could really be implemented). To begin, markets for insurance with a large proportion of high-risk people are problematic. Insurers will have an incentive to try to select only the best risks, leaving those at higher risk to face higher prices and lower quality plans. There are methods of addressing this through a process known as “risk adjustment,” where the government increases the size of the vouchers for sicker people. The problem, however, is that we just aren’t very good at predicting who will be high cost and who will be low. The “state of the art” in risk adjustment is not where it needs to be to make the Ryan plan work.

A second concern with the Ryan plan is that one of the benefits of the Medicare system is that it features lower administrative costs than private plans. By moving people from Medicare to private plans, the Ryan plan is actually expected to increase the overall cost of medical care. This is especially true of risk adjustment is incomplete and private insurers in the Medicare market compete to select and retain good risks as they do in the current market for younger customers. For those who are more worried about the size of government than the cost of health care, this may be a tradeoff worth making. But, it is unclear whether the Ryan plan will succeed in lowering the overall cost of health care. (To be fair, I’m not sure we have any idea how to do it.)

Fortunately, there is a middle way that can move us in the direction of the Ryan plan without relying on a market that doesn’t work and without pushing people into a private sector that may be inherently less efficient than traditional Medicare. The approach leverages Medicare Advantage, the current system where Medicare recipients have the option of choosing to receive health care from private insurers rather than participating in traditional Medicare. Like the Ryan plan, Medicare Advantage plans are paid a fixed amount for every person they enroll, giving them an incentive to keep cost low and quality high. However, unlike the Ryan plan, seniors always have the option to choose to participate in the traditional Medicare plan.

On the bright side, Medicare Advantage plans do a pretty good job of providing seniors with health care, often including benefits beyond those in traditional Medicare at little or no additional cost to seniors. On the other hand, due to a flawed system through which payments to Medicare Advantage plans are set by the government, the government currently pays on average more per enrollee in Medicare Advantage than that person would cost in traditional Medicare.

So, how do we save Medicare? Easy. First, fix the system that sets payments to Medicare Advantage plans. One mechanism that would help is to move to a competitive bidding system, where government payments to plans are based on the lowest bid by any qualifying plan. We might even restrict the number of plans that could operate in a given area, so that plans would have an incentive to bid aggressively in order to get into the market. Second, encourage competition by making it easy for participants to compare and select plans. Set and enforce quality standards so that seniors know that any eligible plan will provide at least a minimum level of benefit.

The third step is, once the Medicare Advantage market is up and running, begin to provide individuals with incentives to choose managed plans when they are a more efficient means of care. In some areas, especially sparsely populated ones, it may never be more efficient to run an HMO-style plan that traditional Medicare due to high administrative costs. In this case, people will choose to remain in the traditional plan. However, in more densely populated areas where efficient delivery networks can be assembled, managed plans may do a better job. Traditional Medicare would always remain an option, but to the extent that it is a more expensive method of delivering care than the managed plans, it would have a higher cost. This is not unlike the choices offered by many large employers (including the State of Illinois), where there are HMO options as well as more expensive “open network” options. Additional subsidies could also be offered to people who are poor or particularly sick.

In the end, we’ll end up somewhere a lot like where the Ryan plan is taking us – with traditional Medicare being replaced by managed care organizations as the predominant form of providing care to the elderly — with a couple of key differences. First, payments to plans will be set via competitive bidding to allow market forces to determine how much the government should be paying for health care rather than a pre-determined formula. Second, traditional Medicare will always remain as a backstop for those who are unable or unwilling to receive adequate care through the managed care system.

Certainly I haven’t said enough to establish whether this kind of plan could actually work or not. But what I like about it is that without the “radical change” that has Speaker Gingrich so rightly concerned. If it doesn’t work, we can always back off by lowering the price of traditional Medicare while we think about what happened and learn from our mistakes. The Ryan plan lacks such a safety valve. So, if we don’t get this huge policy change right the first time, there could be seriously bad consequences for years to come. And, that we are unlikely to get this right the first time is probably the one thing that everyone involved in the discussion will agree on.

Yes, I’ve written about the budget before, and perhaps I’m getting repetitive. But it’s important, and surprising, so I’ll give it another go. But nevermind President Obama’s recent release of a proposed budget for next year. That document is already irrelevant! Let’s start with the current budget.

Current federal spending now is over $3 trillion per year. The deficit is $1.6 trillion. The U.S. House of Representatives approved a plan to cut spending by $60 billion. The Republicans chose not to change spending on defense and homeland security, nor entitlement programs like Social Security, Medicare, and Medicaid. The problem is that then other discretionary spending must be cut for some government agencies by as much as 40%. And yet that total $60 billion cut is only a drop in the bucket. It cuts the annual deficit only from $1.6 trillion to 1.54 trillion!

My point is that you can’t get there from here. First of all, it’s not wise to cast such a wide net, without thinking, making cuts of 40% or more to discretionary programs simply because they are called discretionary. It means cuts to national parks, environmental programs, and federal employees who provide many public services people want.

Second, who says we need to leave defense and entitlements untouched? Within just a few years, Medicaid will cost about $300 billion per year, Medicare will cost $500 billion, and Social Security will cost $800 billion, and defense $800 billion. ALL of domestic discretionary spending will be only $400 billion. By those round numbers, $60 billion from that last category is a 15% cut. The same $60 billion cut proportionally from all of those categories would be only a 2% cut. That’s what I mean by a drop in the bucket.

Anyway, that plan would still cut the deficit only from $1.6 trillion to $1.54 trillion. The ONLY way to make any sizeable dent in the huge $1.6 trillion deficit is to look at all the current spending, not just at $400 billion of domestic discretionary spending, but at the $800 billion of defense spending, $800 billion of social security, $500 billion of Medicare, and/or $300 billion of Medicaid.

And who says taxes are sacrosanct? A $1.6 trillion deficit means we are spending more than our income, so one just MIGHT think that problem can be approached from both ends.

Interesting goings on in the world of government budgets these days. I’ve written in the past about the problems of increasing health care costs in the U.S. and how this is a problem that, at this point, we just don’t know how to solve. Social Security, on the other hand is another matter. Despite the gloom and doom about the coming insolvency of the system, things aren’t really all that bad. (Of course, that statement should be interpreted relative to health care entitlements, but still …) I’m relatively uninformed on the subject, but it seems like, if we wanted to “fix” social security, we could (i) raise taxes, (ii) reduce benefits, (iii) increase the retirement age, or (iv) some combination of these. None of these options is great, but any would work.

Now, you talked about Social Security, Medicare and Medicaid. The truth is Social Security is not the huge contributor to the deficit that the other two entitlements are. … Medicare and Medicaid are huge problems because health care costs are rising even as the population is getting older.

Social Security expenditures are expected to exceed tax receipts this year for the first time since 1983. The projected deficit of $41 billion this year (excluding interest income) is attributable to the recession and to an expected $25 billion downward adjustment to 2010 income that corrects for excess payroll tax revenue credited to the trust funds in earlier years. This deficit is expected to shrink substantially for 2011 and to return to small surpluses for years 2012-2014 due to the improving economy. After 2014 deficits are expected to grow rapidly as the baby boom generation’s retirement causes the number of beneficiaries to grow substantially more rapidly than the number of covered workers. The annual deficits will be made up by redeeming trust fund assets in amounts less than interest earnings through 2024, and then by redeeming trust fund assets until reserves are exhausted in 2037, at which point tax income would be sufficient to pay about 75 percent of scheduled benefits through 2084. The projected exhaustion date for the combined OASI and DI Trust Funds is unchanged from last year’s report.

So, even if NOTHING were done, Social Security would be able to pay at least 75 percent of scheduled benefits through 2084. Like I said, that’s bad, but it could be worse.

What about health care? For that, let’s turn to a new working paper by Kate Baicker and Jon Skinner entitled “Health Care Spending Growth and the Future of U.S. Tax Rates.” Not exactly beach reading. They note that health care spending currently accounts for 17.6 percent of GDP and health care expenditures currently grow, on average, about 2.5 percentage points faster per year than GDP. If this trend continues, health care expenditures are expected to account for 26 percent of GDP by 2035. Of course, escalating health care costs are expected to reduce GDP, so the future might actually be worse. According to the CBO (reported by Newhouse here), if health care cost growth exceeds GDP growth by 1 percentage point (on average) until 2050, this will lead to a 3 – 16% decrease in GDP over what would have happened if there were no gap. Things will be substantially worse if the 2 percentage point gap continues.

What about government revenues? Here’s where it gets really scary. Suppose that health care costs continue to grow at a rate 2.5 percentage points faster than GDP grows. In 2007 (too lazy to look up this year’s number), spending on Medicare and Medicaid was about 4.5 percent of GDP. If the 2.5 percentage point gap continues, CBO estimates that by 2050 spending on Medicare and Medicaid will account for approximately 20 percent of GDP. If this increased expenditure were financed by increasing income taxes and rates for all income groups were increased proportionately, CBO says:

Before any economic feedbacks are taken into account, and again assuming that raising marginal tax rates was the only mechanism used to balance the budget, the tax rate in the lowest tax bracket would have to be increased from 10 percent to 26 percent; the tax rate on incomes in the current 25 percent bracket would have to be increased to 66 percent; and the tax rate in the highest bracket would have to be raised from 35 percent to 92 percent. The top corporate income tax rate would also increase from 35 percent to 92 percent. Such tax rates would significantly reduce economic activity and would create serious problems with tax avoidance and tax evasion. Revenues could fall significantly short of the amount needed to finance the growth of spending, and thus tax rates at this level may not be economically feasible.

Not that they need to, but in the longer term, things are even worse. Chernew, Hirth and Cutler project the meaning of a 2 percentage point health expenditure-GDP gap until 2083 and find that, on average, 118 percent of all real income growth between now and 2083 will be devoted to health expenditures. The Newhouse study illustrates this point with a graph showing that if a household has about $40,000 to spend on everything other than health care in 2008, under the current projections it will have about $30,000 to spend on everything else in 2084.

So, the comparison between Social Security and health care is pretty clear. If nothing is done, Social Security will be able to pay at least 75% of benefits through 2084. If nothing is done on the health care front, (according to the CBO report) “if health care costs per beneficiary grew an average of 2.5 percentage points faster than GDP per capita each year, as they have over the past four decades, and the spending was financed solely with a proportional increase in income tax rates, the economic costs would be significant and the circumstance probably impossible to sustain through 2050.”